A VC explains why he prefers startups that burn lots of money

Founders Fund VC Scott NolanTwitter/@ScottNolanFounders Fund VC Scott Nolan

VC Scott Nolan, a partner at Founders Fund — best known as Peter Thiel’s venture firm — penned an article for TechCrunch that explained the prevailing investment logic in Silicon Valley brilliantly, called Burn Rate Doesn’t Matter.

He’s looking for companies that are not profitable as profits indicate to him that the startup doesn’t really know what to do with money. He explains:

At Founders Fund we avoid investing in companies unless they are consuming cash. We’re here to invest when doing so will bring about positive progress faster, which often manifests as the conversion of cash into assets and increased burn. Cash-flow-positive businesses are usually past this inflection point, or simply don’t have enough ideas about what valuable things to do with more money.

Nolan, who is literally a rocket scientist and was an early employee at SpaceX, even shared an algebraic equation to represent the ideal amount of money a company should be spending:

Burn rate [$US/month] = Milestones/Month x Cost/Milestone = Speed/Efficiency

His basic point is that it’s not how much money a company is burning, it’s what the company is spending on that matters.

Ideally, he’s looking for companies that are spending money to reach an R&D milestone never achieved before.

But he also equates companies that are careful with their cash to “doomsday preppers hunkering down in the final moments before Y2K.” In contrast, “The most valuable, important companies of the decades ahead are building the future today, executing quickly and burning money in the process.”

Of course, he acknowledges that there are risks with his approach. If “the financing world suddenly became less optimistic, these ‘fast-inefficient’ companies may need to adapt or die.”

The financing world tends to become less optimistic when a bubble bursts and all of the money drains away, for instance. The debate is raging now as to how much of a bubble the tech industry is in right now. We’d argue that investors who are actively looking for companies with high burn rates lends itself to the “we’re in a bubble” camp.

There’s another component to the Silicon Valley investing logic that Nolan didn’t really touch on.

Venture investors have a different agenda overall than startup founders. They are playing a numbers game, knowing that they will make most of their return on only a small number of their investments: 15 out of 200 startups that get funded will generate 97% of the industry revenue, VC Marc Andreessen once explained.

That means that VCs are looking for “the extreme outlier,” that long-odds bet. The ones that don’t make it are simply part of their investment equation.

NOW WATCH: Peter Thiel’s 3 Keys For Building A Successful Startup

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